Are you paying yourself correctly? Depending on your business legal entity, it can be called a draw or distribution when the business pays you. When you first started your business, you may have been so busy focusing on the first sale that you probably didn’t think about how much money you needed the business to make to support your current standard of living. A draw or distribution feels hard to do when the business is just starting or when the business experiences a slow month for sales. If you don’t have a clear, repeatable plan for how to pay yourself from the business, it’s easy to make the mistake of commingling your business and personal finances, or create more administrative headaches come tax time due to inconsistent draws and distributions. If you’ve been afraid to pay yourself and are looking for the best and consistent way for your small business to pay you, keep reading to learn the two methods of paying yourself from the business and how often you should pay yourself.
Question: How do you currently pay yourself from your small business?
A. I don’t. My business isn’t making enough money yet.
B. I withdraw money from the ATM whenever I need cash.
C. I use my business credit card to pay for personal expenses when I see there is enough money.
D. Both B & C
E. I write myself a check from the business account and deposit it into my personal checking account. (Or I do an online transfer between accounts.)
Correct Answer: E
Best Ways to Pay Yourself from Small Business
There are two options in figuring out how and how much to pay yourself from your small business. Decide upfront which option is best for you, and minimize inconsistencies that can add to administrative headaches and IRS issues.
Option 1: Set Amount
With this option, you will choose a consistent amount that you will pay yourself each month (i.e. $2,000 per month) and/or each paycheck (i.e. $500 per paycheck) and frequency (i.e. once a month, twice a month, or every week).
If you’re not sure what amount to select, the first step is to create a personal budget and determine how much income you need to earn to pay your personal bills. Then, evaluate if the business can support this draw or distribution.
Option 2: Percentage of Profits
If you have other sources of income or you’re worried about the business’ fluctuating income, you can choose to pay yourself a percentage of each month’s profits. Another way to look at it is that you’re paying yourself on a 100% commission.
By choosing this option, you pay yourself based on a pre-determined percentage (i.e. 25%) of each month’s profits. You will only pay yourself after month-end when you’ve calculated your total sales, cost of goods sold, total expenses, and net profit.
How Often Should You Pay Yourself
- Twice a month – If you selected to pay yourself a set amount per month (Option 1), I recommend paying yourself twice a month.
- Tip: I like the 7th and 21st of the month. Since many of us have big bills like a personal mortgage due on the 1st of the month, picking a pay day like the 21st of the month gives you plenty of time for the business to write a paycheck, deposit the check into your personal checking account, and set up payment to arrive on time for those personal bills due on the 1st of the month.
- Once a month – If you are paying yourself a set % based on the business profits (Option 2), I recommend only paying yourself once a month.
- Tip: I prefer pay days on the 7th of the month. Picking this date will allow you time to close the prior month’s books, calculate your draw or distribution amount, and write yourself a check.
Steps: How to Pay Yourself from Your Small Business
There are three ways to pay yourself from your small business:
- Write yourself a check from your business checking account.
- Set up an online draft from the business checking account to your personal checking account.
- Create a new payee via online banking for yourself and have the business send you payments.
Remember to add details in the check memo area to indicate this was your pay. When you do that, you’ll have a clean paper or digital trail showing that money was taken out of the business in the form of a draw or distribution. By doing this, if you are ever audited or your CPA wants to re-calculate the numbers, you can easily review the bank statements of cleared checks and refer to the memos in online drafts for verification.
Please note that nowhere in the steps above states that you can use your business credit card as a “pay day” method of the business paying you. Do not purchase personal items on your business credit card as a way to pay yourself from the business! I had a client do this prior to working with me, because she was afraid to pay herself a consistent paycheck from her seasonal business. Big mistake! By using her business credit card for both personal and business items, she had commingled funds, which can lead to accounting and audit nightmares. Furthermore, it can lead to legal protection implications due to “piercing the corporate veil” and the LLC protection may no longer apply.
Summary: Which Pay Day Option Is Better for Small Business Owners?
If you want less time commitment, picking a set amount to pay yourself (Option 1) is the easier method. You can set up automatic payments from your business bank account and “forget it.” However, you’ll need to make sure your business generates enough income to support your paycheck. On the other hand, if you need more flexibility because your business is seasonal or you’re not sure if the business can support a consistent pay day amount, give yourself a percentage of each month’s profits (Option 2). Whichever option you select, create the habit and and don’t skip pay days or get behind on calculating your net profit for the month. When it comes time for your CPA to do taxes or if you’re ever audited by the IRS, it will be easier to spot the owner’s draw and distribution amounts and not accidentally claim those as business deductions.
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